In a new revenue ruling, the IRS says that a partnership that converts to a corporation under the check-the-box rules or under a state formless conversion law can also make an immediate S election.

Background on Check-the-Box Rules

Under the IRS's check-the-box rules, a partnership can elect out of partnership tax treatment and choose instead to be treated as an association taxable as a corporation [Reg. § 301.7701-3(c)(1)(i)]. Alternatively, state law may provide for a formless conversion of a partnership into a corporation without an actual transfer of partnership's assets or interests to a new corporation. For federal tax purposes, a partnership that converts to a corporation under a state law formless conversion statute will be treated in the same way as a partnership that makes an election to be treated as an association under the check-the-box rules [Rev. Rul. 2004-59].

Thus, in either event, the partnership is deemed to have contributed all of its assets and liabilities to the corporation in exchange for stock in, and immediately thereafter, the partnership is deemed to have liquidated, distributing the stock of the corporation to its partners [Reg. §301.7701-3(g)(1)(i)].

The S Election

Assuming it qualifies as a small business corporation, the converted partnership can also opt to be taxed as an S corporation. An S election can be made at any time during the tax year before the election year or it can be made during the first two months of the election year.

Timing Matters. An S election made on or before the 15th day of the third month of a year will generally be effective retroactively to the first day of the tax year.

However, an S election made during a tax year will be delayed until the following tax year if the corporation was not a small business corporation during the entire portion of the tax year before the date of the election. For example, the corporation would not qualify as a small business corporation and the election would not apply retroactively if the corporation had a shareholder other than individual (including a partnership) during any part of the tax year before the election is made (see Sec. 1361(b)(1)(B)).

The election will also be delayed if any person who held stock in the corporation at any time during the part of the tax year before the election, and who does not own stock at the time of the election, does not consent.

Crux of New Revenue Ruling

The ruling helps answer this key question:

    Can a partnership's conversion to a corporation and its election of S status take effect simultaneously?

Here's how the IRS chooses to answer the question now:

    Yes. When a partnership becomes a corporation for federal tax purposes, the corporation is eligible to elect to be taxed as an S corporation effective its first taxable year [Rev. Rul. 2009-15].

Let's see how this can play out:

    Example: On January 1, 2009, Alpha Operations, a calendar year taxpayer, is organized as an unincorporated entity that is classified as a partnership for federal tax purposes. Alpha subsequently makes a check-the-box election to be treated as a corporation for federal tax purposes, effective January 1, 2010. On February 1, 2010, Alpha files an election to be taxed as an S corporation, effective January 1, 2010. There is no person who held stock in Alpha on January 1, 2010, who does not hold stock at the time of the S election.

    Result: When Alpha elects to be classified as a corporation for federal tax purposes, the Alpha partnership is treated as contributing all of its assets and liabilities to the Alpha corporation in exchange for stock and then liquidating by distributing the stock to its partners. Under the check-the-box rules, these steps are treated as occurring immediately before the close of the day before the election is effective.

    Thus, the Alpha partnership's tax year ends on December 31, 2009, and the Alpha corporation's first tax year begins on January 1, 2010. The Alpha partnership is not deemed to own the stock of the Alpha corporation at any time during the corporation's first tax year beginning January 1, 2010. Consequently, the Alpha corporation qualifies as a small business corporation as of the first day of the tax year X and its S election can take effect as of January 1, 2010. In other words, there is no momentary holding of Alpha corporation stock by the Alpha partnership that would disqualify the corporation as a small business corporation eligible to elect S status.

    Additionally, because the Alpha partnership's tax year ends immediately before the close of the day on December 31, 2009, and the corporation's first tax year begins at the start of the day on January 1, 2010, the deemed steps will not cause the corporation to have a short tax year in which it was a C corporation.

- Last Updated: 08/04/2009